The market for commercial mortgage bonds has weakened significantly since the beginning of the year, raising questions about the ability of borrowers in certain parts of the country to refinance billions of dollars of maturing loans on office buildings, hotels and shopping centers.
While securitization accounts for between 20% and 25% of all commercial real estate lending, or roughly $100 billion a year, properties in secondary and tertiary markets are largely dependent on it for financing. And as investors demand higher yields on these bonds, lenders that specialize in underwriting mortgages to be used as collateral are starting to lose money; some are cutting staff or closing shop entirely.
Redwood Trust is one of these. The real estate investment trust started originating senior commercial mortgages for sale to conduits a few years ago, when there was a shortage of capacity. And through 2014, originating senior commercial mortgages for securitization was "highly profitable," President Brett Nicholas said in an earnings conference call last week.
But in recent quarters competition from banks and insurance companies as well as increased market volatility have "significantly eroded" that performance, and the company thinks that this is "unlikely to change in the foreseeable future."
Redwood unloaded all but $4 million of the senior loans in its portfolio in its most recent securitization — "albeit at a small loss," Nicholas said.
The risk premiums that investors are demanding on commercial mortgage bonds have increased dramatically. The senior, triple-A-rated tranches issued by conduits are now paying 165 basis points over the swaps benchmark, versus 105 basis points six months ago, according to Kroll Bond Rating Agency.
Spreads on tranches with the lowest investment grade ratings, triple-B-minus, are paying a whopping 775 basis points over swaps — a level comparable to junk-rated corporate bonds. Six months ago, triple-B-minus tranches traded at a spread of just 400 basis points.
With yields on commercial mortgage bonds so high, it is unprofitable to securitize loans made late last year with low interest rates. There would not be enough cash coming in from the collateral to cover interest payments on the bonds issued by a securitization trust. So lenders have had to sell loans to conduits at a discount to face value. And they must charge higher interest rates on any new loans that they hope to sell.
As a result, just $10.7 billion of commercial-mortgage-backed securities was issued in the first two months of the year, down 34% from the same period of 2015. Kroll sees another $8 billion in the pipeline for March; after that, no one knows what to expect.
The electronic files on collateral for prospective CMBS that Kroll reviews "seem to be cluttered with numerous repeat loans, and some issuers and originators are indicating they don't have visibility regarding issuance beyond April," the rating agency stated in a report published Tuesday.
There are currently some 40 conduit lenders; Kroll would not be surprised to see eight to 10 of them exit the market.
Excess lending capacity and market volatility are not the only things taking a toll on the commercial mortgage bond market.
The banks that bundle these loans into collateral for bonds are struggling with new registration and reporting requirements. Among other things, Regulation AB II, which took effect in November, requires an executive to personally vouch that information provided to a deal's investors is accurate.
That mandatory certification "creates reputational risk for institutions and individuals," said Peter McKee, a partner in the law firm Alston & Bird's finance group. In the past, the issuer was responsible for a general degree of oversight of loan sellers, but now "issuers have to bird-dog all sellers' loans, not just their own. … As a practical matter, folks are developing protocols to scrub loans and hiring additional people, and this adds cost and time."
The burden is compounded by the fact that larger loans in deals, which are the most complicated, tend to close later. "This exacerbates the timing element," McKee said.
Investors also take issue with some of the lenders. "Investors are saying, 'We're uncomfortable with some of these new startups, they have insufficient capital, underwriting is too aggressive, and their cost of funds is higher, which means they are making riskier loans,' " said Pat Sargent, another partner in Alston & Bird's finance group.
Additional regulation that takes effect in December that requires sponsors to retain an economic interest in their deals is expected to add even more to the cost of financing commercial real estate via securitization. The Commercial Real Estate Finance Council (CREFC) estimates that so-called risk-retention rules will add at least 10% to the interest rate that a borrower pays.
In prepared testimony before the House Financial Services Committee in late February, the council's chief executive, Stephen M. Renna, said his group's members, which include both issuers and investors, believe that much of the current spread widening in CMBS has been driven by regulatory concerns.
The trade group has been lobbying Congress to exempt certain kinds of mortgage bonds from risk-retention rules. It argues that bonds backed by a single, large mortgage on one asset such as a mall, hotel or office building are easier to analyze, and perform better, than securitizations of multiple loans.
On Wednesday, the House committee approved a bill introduced by Rep. James French Hill, R-Ark., that would do just that.
For now, the commercial real estate market itself is fine; the vast majority of loans are performing and property values are strong.
Moreover, commercial mortgage bonds have little exposure to buildings with tenants in the oil and gas industries, a source of major concern for the corporate bond and equities markets.
And so far, much of the slack in conduit lending is getting picked up by banks and insurance companies, participants say.
"As large loans come up for refinancing, the life companies are going to look to feed," said Rick Jones, co-chair of the finance and real estate group at the law firm Dechert. "The life companies are doing a little happy dance; they have a competitive advantage, at least through part of the capital stack."
But insurance companies, in particular, have a strong preference for high-quality properties in major metropolitan markets. They are less likely to refinance loans maturing on properties in secondary markets such as Denver, Baltimore or Kansas City.
It is also unclear whether banks and insurers have the capacity to tackle the more than $80 billion of securitized commercial mortgages that are set to mature this year.